It's the last thing Dollar General and Family Dollar Stores need right now: an extra $15 a week deducted from the wages of customers already living paycheck to paycheck.

CHRIS BURRITT

It's the last thing Dollar General and Family Dollar Stores need right now: an extra $15 a week deducted from the wages of customers already living paycheck to paycheck.

Under the taxes-and-spending deal hammered out this month between Congress and the Obama administration, Americans will pay 2 percent more in payroll taxes. For an average Dollar General customer earning $40,000 annually, that adds up to $800 per year. And that's money they potentially would have spent at dollar stores, said Edward Kelly, an analyst at Credit Suisse in New York.

Dollar General and Family Dollar, respectively the No. 1 and No. 2 industry players, are already facing a resurgent Wal- Mart Stores, which has put more items on shelves and emphasized low prices in its advertising. Family Dollar, based in Matthews, N.C., tumbled 13 percent Jan. 3, its biggest drop in more than 12 years, after posting weaker profit margins and cutting its full-year profit outlook.

The tax increase is "like a splash of cold water," Kelly said in an interview. "It represents a direct reduction of spending by the lower-end consumer."

Family Dollar is trading at a 26 percent discount to the Standard & Poor's 500 Retailing Index on a price-to-earnings basis after commanding a premium to the measure as recently as July.

The drag from higher taxes will reach beyond discount retailers, according to Morgan Stanley. The bank said it expects department-store and specialty-retail stocks to lag behind the S&P 500.

"Weak disposable income growth, driven by the payroll tax increase, and a low savings rate should offset housing recovery benefits and result in disappointing sales," Kimberly Greenberger, a Morgan Stanley analyst in New York, wrote in a note Monday.

Three years ago, the dollar stores seemed positioned to thrive in a weak economy and were even stealing customers from Wal-Mart. As more low-income Americans made mid-week trips to Dollar General and Family Dollar, the chains added such enticements as more packaged food, health and beauty products, and frozen dinners.

The strategy helped attract shoppers. In the last eight quarters, Dollar General sales at stores open at least a 13 months have climbed an average of 5.5 percent. But much of the new merchandise was low margin, and shoppers with little spending power declined to buy higher margin seasonal items such as toys and clothing. The chains were forced to discount such merchandise, and profit took a hit.

"Family Dollar's principal mistakes were undertaking too many margin-depressing initiatives at the same time and not accurately anticipating the magnitude of the discretionary weakness," John Heinbockel, an analyst at Guggenheim Securities in New York, wrote in a Jan. 4 note.

The fallout became clear during the holiday shopping season, when Family Dollar shoppers focused on necessities while shunning higher-margin apparel, toys and other non-essentials. Recently, Family Dollar reported its first quarterly decline in net income in almost five years.

Gross margin, the fraction of sales left after subtracting the cost of goods sold, may remain under pressure for the rest of the year as the company continues to add more consumables and discretionary sales remain weak, said Anthony Chukumba, an analyst at BB&T Capital Markets in New York.

Family Dollar Chief Executive Officer Howard Levine is all too aware of how higher payroll taxes will affect shoppers.

"Our customers are clearly making choices," he said on a Jan. 3 conference call. Higher payroll taxes "go against our customers' wallet. Clearly they do not have as much for discretionary purchases than they did."

Dollar General, which said last month it cut holiday prices, is headed for the slowest annual earnings growth in the three years since its initial public offering, according to analysts surveyed by Bloomberg.

Meanwhile, Wal-Mart is gaining ground in the U.S. Two years ago, the world's largest retailer began returning thousands of items to shelves in an effort to persuade customers to do all their shopping at its stores. The strategy worked, and Wal-Mart has posted five straight quarters of U.S. same-stores sales growth.